Learn About Material Participation in a Business
Material participation and passive activity loss rules were set up by the IRS to keep business owners who don't work day-to-day in the business from profiting from tax losses. We'll look at how material participation of a business owner is determined for a business year and then the non-ability of the owner to take a deduction for a business loss in that year.
Material Participation in a Business
The IRS has determined that an individual materially participates in business activities if he or she participates on a "regular, continuous and substantial basis." If it is determined that an individual's participation is not material, he/she cannot deduct losses to the same extent as a business owner who does materially participate in the business.
How Material Participation Is Determined
Material participation is determined each year. The IRS has seven tests to determine material participation:
- The taxpayer works 500 hours or more during the year in the activity.
- The taxpayer does substantially all the work in the activity.
- The taxpayer works more than 100 hours in the activity during the year and no one else works more than the taxpayer.
- The activity is a significant participation activity (SPA), and the sum of SPAs in which the taxpayer works 100-500 hours exceeds 500 hours for the year.
- The taxpayer materially participated in the activity in any 5 of the prior 10 years.
- The activity is a personal service activity and the taxpayer materially participated in that activity in any 3 prior years.
- Based on all of the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during such year. However, this test only applies if the taxpayer works at least 100 hours in the activity, no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.
An Example of Material Participation Determination
Joe and Sally Cotler are a husband and wife who are members (owners) of an LLC. Each of them has a 50% membership percentage. Sally does the majority of the work in the business; Joe offers comments and suggestions, and he occasionally helps with fixing things.
He does not work over 100 hours a year, so he is not materially participating in the business.
Why Material Participation Is Important for Taxes
Determining whether a business owner's participation in the day to day activities of the business affects the owner's taxes. The owner's taxes are affected in particular if the business has a loss in any one year. In particular, the IRS labels losses to a business owner who does not materially participate in the business as "passive activity losses."
If a business owner materially participates in the business, and the business has losses, the owner can take the full amount of his or her losses on a personal tax return. If the owner doesn't materially participate and the business has losses, the owner's losses are limited to the amount of profits.
- An Example: Joe and Sally Cotter's business has a loss of $10,000 for the year. They have no income other than the business. Their LLC operating agreement splits profits and losses equally. Since Sally actively participates in the business, she can deduct her full $5,000 share of the losses. But since Joe didn't materially participate, he can't deduct any of his $5,000 shares because there was no income to offset the loss.
- A Disclaimer: Determination of "material participation," and passive activity rules are complicated. This article and others on this site are not intended to be tax advice. If you think lack of material participation may be an issue in your business, check with your tax adviser. This article by the IRS on Passive Activity Losses includes more information on this subject.